GAO Report Suggests Annuities as Retirement Income Option

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The U.S. Government Accountability Office (GAO) reports that financial experts typically recommend that middle-net-worth retirees use a portion of their savings to buy an income annuity (immediate annuity) to help meet necessary retirement expenses. The report, Ensuring Income throughout Retirement Requires Difficult Choices, finds that while Social Security continues to be the primary source of fixed income in retirement, it is not enough to meet the income needs of most retirees. Also, the shift from employer-sponsored defined benefit pension plans to defined contribution plans, coupled with increasing life expectancies, is forcing retirees to assume more responsibility for managing their savings to ensure that they have sufficient income throughout retirement. An income annuity is an alternative to self-managing savings that offers retirees a steady source of income they won’t outlive.

Why income annuities? Generally, an income annuity, also referred to as an immediate annuity, is issued by an insurance company. It is typically purchased with a single lump sum of money (premium) paid to the issuer in exchange for payments made for life (single life income annuity), or for the joint lives of the annuity owner and his or her spouse or partner (joint and survivor income annuity). Payments generally begin no later than one year from the date the issuer receives the premium. The GAO report suggests income annuities:

  • Help protect retirees against the risk of underperforming investments
  • Help protect retirees against the risk of outliving their savings (longevity risk)
  • Help relieve retirees of the task of managing their investments at older ages when their capacity to do so may be diminished, and
  • Provide a base of guaranteed income that may serve as a dependable “cushion” for retirees who might otherwise spend too little for fear of outliving their assets (guarantees are subject to the claims-paying ability of the annuity issuer)

Why income annuities may not work Income annuities aren’t for everyone nor do they work in every situation. Particularly, income annuities may not be appropriate for people:

  • With predictably shorter-than-normal life expectancies
  • Who have limited savings, since the funds used to purchase income annuities generally are not available to cover large, unanticipated expenses
  • Who are concerned about income taxes, since the income from annuities purchased with nonqualified funds is typically taxed as ordinary income, whereas some or all of the investment return on liquidated savings in stocks, bonds, or mutual funds may be taxed at lower capital gains or dividend tax rates
  • Who want to provide a bequest of their assets at their death

When might an income annuity be appropriate? The GAO study describes examples when an income annuity may be appropriate. In one scenario, the study suggests that a household with a total net wealth of $350,000 to $370,000, of which $170,000 to $190,000 is savings (and which does not have a defined benefit pension plan), should consider purchasing an income annuity with a portion of their savings. Retirees with defined benefit pension plans should consider an income annuity option rather than taking a lump-sum rollover to an IRA. Conversely, an income annuity may not be as useful for households with significantly greater net wealth or those households with appreciably less net wealth.

Proposals to access annuities and increase financial literacy Typically, defined contribution plan sponsors do not offer account holders income annuities as an option. In response, the study makes several recommendations to promote the availability of income annuities for defined contribution plan distributions. These proposals include legislation that would require plan sponsors to offer income annuities as a choice to plan participants, or set income annuities as the default election for plan participants when accessing defined contribution plan benefits. The study also recommends options aimed at improving individuals’ financial literacy, particularly concerning the risks and available choices for managing income throughout retirement.

Report recommendations The report seeks to offer options to retirees on how to have an adequate income throughout retirement. Generally, the study suggests that middle-income retirees should consider delaying Social Security retirement benefits at least until full retirement age, consider working longer, draw down savings systematically and strategically (typically at an annual rate of between 3% and 6%), elect an annuity instead of a lump sum withdrawal for employer-sponsored defined benefit plans, and for retirees who don’t have a defined benefit plan, purchase an income annuity with some of their savings. To view the report in its entirety, go to (

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The Debt Ceiling and the Road Ahead

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After all the debate in recent weeks over issues related to raising the nation’s debt limit, it’s hard to know exactly what might happen after August 2. Borrowing represents more than 40% of the nation’s expenses, and any default on the country’s obligations would be unprecedented.

As a rule, panic generally doesn’t help you make wise financial decisions. That’s why now might be a good time to review your portfolio to see if you have more exposure to a particular asset class than you’d prefer, regardless of what happens in Washington. And as the situation evolves, here are some mileposts that bear watching:

Auctions of Treasury securities The yield on the 10-year Treasury note can serve as a barometer of anxiety levels; the higher the yield goes, the more bond prices will fall, indicating increasing anxiety in the bond markets.

Regardless of whether the debt ceiling stays the same, several significant auctions of Treasury securities are scheduled shortly after the August 2 deadline. Bids for 3- and 10-year notes and 30-year bonds will begin on August 3, and auctions will take place August 9–11. More importantly, the nonprofit Bipartisan Policy Center (BPC) estimates that payment of roughly $90 billion on maturing Treasury securities is due on August 4.

The difficulty in producing an agreement to raise the limit has led two major credit rating agencies to announce they are officially reviewing the United States’ historically impeccable credit rating. Even if the Treasury attempts to avoid defaulting on Treasury securities by prioritizing payment of its obligations, the rating agencies have warned that any such move would likely trigger a downgrade, especially if no consensus has been reached on how to tackle the deficit.

A lowered credit rating would mean the United States would have to pay more to borrow in the future, making the national debt problem even worse in the long term. That’s because the greater uncertainty about the country’s willingness and ability to pay its bills would likely lead both domestic and foreign investors to demand greater compensation for buying Treasuries.

Bonds and non-Treasury borrowing Higher interest rates for Treasury bonds might also result in higher interest rates on other, nongovernmental loans such as mortgages and consumer credit. Since many interest rates are based on Treasury rates, rates generally would likely be affected. And since bond prices fall when rates rise, you should keep an eye on your bond portfolio.

One indicator of investors’ assessment of the risks of Treasury bonds compared to other debt is what’s known as the Baa/Treasury spread, which measures the difference between the yields of corporate bonds rated Baa and 10-year Treasuries. Normally, investors demand a higher yield for corporates because of their greater risk of default. The narrower the gap between the two, the less risky investors feel corporate bonds are compared to Treasuries.

Higher rates also could mean reduced credit availability. Some observers worry that tighter credit on top of a weak housing market could hamper economic recovery. And even if there were technically no default, the mere absence of an agreement that addresses the issue before August 2 would likely raise the global anxiety level substantially.


The stock market hates uncertainty, and the greater the uncertainty, the greater the potential impact on stocks. If investors become concerned about the availability of credit, they could punish companies that rely heavily on it. Fortunately, in the wake of the 2008 financial crisis, many companies took advantage of low interest rates to issue new bonds and/or refinance older debt. Also, many companies, fearing a sequel to 2008, have been sitting on a larger amount of cash than usual, which could help cushion the impact of tighter credit.

Markets also will be assessing the impact of either severe budgetary cutbacks or prioritization of existing government bills on the already fragile economy as a whole. If either seems to pose a serious threat to consumer spending, equities could feel the fallout.

Payment of government benefits, contracts, and departments According to the BPC, the country will have roughly $172.4 billion coming in during the rest of August to pay $306.7 billion of scheduled expenditures. Without an increase in the borrowing limit, the Treasury will have to rely on those revenues and prioritize which of its existing bills to pay. Here are some of the major payments scheduled for shortly after the Treasury's August 2 deadline:

Social Security payments for beneficiaries who began receiving benefits before May 1997 or who receive both benefits and Supplemental Security Income (SSI) are scheduled for August 3. Benefits for recipients with birth dates between August 1–10 are scheduled for the following Wednesday, August 10. Those with birth dates between the 11th and the 20th are scheduled for August 17, and August 24 is the date for birthdays between the 21st and the 31st.

For military service members, August 15 is the date for the scheduled mid-month installment of active duty pay, with the associated “advice of pay” notice set for August 5. And as previously noted, an estimated $90 billion in Treasury debt payments are due August 4.

Medicare, Medicaid, Social Security benefits, defense vendor payments, interest on Treasury securities, and unemployment insurance represent some of the federal government’s largest costs for the month. The BPC estimates that covering those costs completely would leave no funds for such obligations as the Departments of Education, Labor, Justice, and Energy; federal salaries and benefits; military active duty pay and veterans' affairs; the Federal Transit Administration, Federal Highway Administration, Small Business Administration, and the Environmental Protection Agency; Housing and Urban Development and federal food and nutrition services; and IRS refunds.

The outlook for an agreement Plans have been put forward to tie increases in the debt ceiling to a balanced budget constitutional amendment, to specific spending cuts, and to a combination of spending cuts and revenue increases. There also has been talk of a fail-safe plan that would give the president authority to increase the debt ceiling in stages before the 2012 election; Congress would be able to vote against those increases but would not be able to effectively prevent them.

One proposal that seems to have a chance of winning at least some bipartisan support is based on months of negotiations by the “Gang of Six” senators from both parties. The proposal is designed to cut an estimated $3.7 trillion from the deficit over 10 years through such measures as shrinking the current six tax brackets to three, eliminating the alternative minimum tax, revising how Social Security cost-of-living increases are calculated, and reducing tax deductions for such items as mortgage interest, charitable donations, and retirement savings.

All parties have agreed it’s important not to jeopardize the country’s financial health. As the road to a resolution unwinds, it can be helpful to keep calm and monitor the situation.

All investing involves risk, including the risk of loss of principal, and there can be no guarantee that any investment strategy will be successful.

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Make sure you contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you reach your retirement goals that much sooner.

401(k) Plans

Qualified cash or deferred arrangements (CODAs) permitted under Section 401(k) of the Internal Revenue Code, commonly referred to as “401(k) plans,” have become one of the most popular types of employer-sponsored retirement plans.

How does a 401(k) plan work?

With a 401(k) plan, you elect either to receive cash payments (wages) from your employer immediately, or defer receipt of a portion of that income to the plan. The amount you defer (called an “elective deferral” or “pretax contribution”) isn’t currently included in your income; it’s made with pretax dollars. Consequently, your federal taxable income (and federal income tax) that year is reduced. And the deferred portion (along with any investment earnings) isn’t taxed to you until you receive payments from the plan.
Example: Melissa earns $30,000 annually. She contributes $4,500 of her pay to her employer’s 401(k) plan on a pretax basis. As a result, Melissa’s taxable income is $25,500. She isn’t taxed on the deferred money ($4,500), or any investment earnings, until she receives a distribution from the plan.
You may also be able to make Roth contributions to your 401(k) plan. Roth 401(k) contributions are made on an after-tax basis, just like Roth IRA contributions. Unlike pretax contributions to a 401(k) plan, there’s no up-front tax benefit, but qualified distributions from a Roth 401(k) account are entirely free from federal income tax.

When can I contribute?

You can contribute to your employer’s 401(k) plan as soon as you’re eligible to participate under the terms of the plan. In general, a 401(k) plan can make you wait up to a year before you’re eligible to contribute. But many plans don’t have a waiting period at all, allowing you to contribute beginning with your first paycheck.
Some 401(k) plans provide for automatic enrollment once you’ve satisfied the plan’s eligibility requirements. For example, the plan might provide that you’ll be automatically enrolled at a 3% pretax contribution rate (or some other percentage) unless you elect a different deferral percentage, or choose not to participate in the plan. This is sometimes called a “negative enrollment’ because you haven’t affirmatively elected to participate—instead you must affirmatively act to change or stop contributions. If you’ve been automatically enrolled in your 401(k) plan, make sure to check that your assigned contribution rate and investments are appropriate for your circumstances.

How much can I contribute?

There’s an overall cap on your combined pretax and Roth 401(k) contributions. You can contribute up to $16,500 of your pay ($22,000 if you’re age 50 or older) to a 401(k) plan in 2011. If your plan allows Roth 401(k) contributions, you can split your contribution between pretax and Roth contributions any way you wish. For example, you can make $9,500 of Roth contributions and $7,000 of pretax 401(k) contributions. It’s up to you.
But keep in mind that if you also contribute to another employer’s 401(k), 403(b), SIMPLE, or SAR-SEP plan, your total contributions to all of these plans—both pretax and Roth—can’t exceed $16,500 ($22,000 if you’re age 50 or older). It’s up to you to make sure you don’t exceed these limits if you contribute to plans of more than one employer.

Can I also contribute to an IRA?

Yes. Your participation in a 401(k) plan has no impact on your ability to contribute to an IRA (Roth or traditional). You can contribute up to $5,000 to an IRA in 2011, $6,000 if you’re age 50 or older (or, if less, 100% of your taxable compensation). But, depending on your salary level, your ability to make deductible contributions to a traditional IRA may be limited if you participate in a 401(k) plan.

What are the income tax consequences?

When you make pretax 401(k) contributions, you don’t pay current income taxes on those dollars (which means more take-home pay compared to an after-tax Roth contribution of the same amount). But your contributions and investment earnings are fully taxable when you receive a distribution from the plan.
In contrast, Roth 401(k) contributions are subject to income taxes up front, but qualified distributions of your contributions and earnings are entirely free from federal income tax. In general, a distribution from your Roth 401(k) account is qualified only if it satisfies both of the following requirements:
  • It’s made after the end of a five-year waiting period
  • The payment is made after you turn 59½, become disabled, or die
The five-year waiting period for qualified distributions starts with the year you make your first Roth contribution to the 401(k) plan. For example, if you make your first Roth contribution to your employer’s 401(k) plan in December 2011, your five-year waiting period begins January 1, 2011, and ends on December 31, 2015. Each nonqualified distribution is deemed to consist of a pro-rata portion of your tax-free contributions and taxable earnings.

What about employer contributions?

Many employers will match all or part of your contributions. Your employer can match your Roth contributions, your pretax contributions, or both. But your employer’s contributions are always made on a pretax basis, even if they match your Roth contributions. That is, your employer’s contributions, and investment earnings on those contributions, are always taxable to you when you receive a distribution from the plan.

Should I make pretax or Roth contributions?

Assuming your 401(k) plan allows you to make Roth 401(k) contributions, which option should you choose? It depends on your personal situation. If you think you’ll be in a similar or higher tax bracket when you retire, Roth 401(k) contributions may be more appealing, since you’ll effectively lock in today’s lower tax rates. However, if you think you’ll be in a lower tax bracket when you retire, pretax 401(k) contributions may be more appropriate. Your investment horizon and projected investment results are also important factors. A financial professional can help you determine which course is best for you.
Whichever you decide—Roth or pretax—make sure you contribute as much as necessary to get the maximum matching contribution from your employer. This is essentially free money that can help you reach your retirement goals that much sooner.

What happens when I terminate employment?

Generally, you forfeit all contributions that haven’t vested. “Vesting” means that you own the contributions. Your contributions, pretax and Roth, are always 100% vested. But your 401(k) plan may generally require up to six years of service before you fully vest in employer matching contributions (although some plans have a much faster vesting schedule).
When you terminate employment, you can generally leave your money in your 401(k) plan until the plan’s normal retirement age (typically age 65), or you can roll your dollars over tax free to an IRA or to another employer’s retirement plan.

What else do I need to know?

  • Saving for retirement is easier when your contributions automatically come out of each paycheck
  • You may be eligible to borrow up to one-half of your vested 401(k) account (to a maximum of $50,000) if you need the money
  • You may be able to make a hardship withdrawal if you have an immediate and heavy financial need. But this should be a last resort—hardship distributions are taxable events (except for Roth qualified distributions), and you may be suspended from plan participation for six months or more
  • If you receive a distribution from your 401(k) plan before you turn 59½, (55 in certain cases), the taxable portion may be subject to a 10% early distribution penalty unless an exception applies
  • Depending on your income, you may be eligible for an income tax credit of up to $1,000 for amounts contributed to the 401(k) plan
  • Your assets are generally fully protected from creditors in the event of your, or your employer’s, bankruptcy
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Even if your asset allocation was right for you when you chose it, it may not be right for you now. It needs to change as your circumstances and priorities change.

Asset allocation and diversification cannot guarantee a profit or insure against a loss. There is no guarantee that any investment strategy will be successful; all investing involves risk, including the possible loss of principal.

No simple answers

You may have heard this widely known rule of thumb: To figure out the percentage of your investments that should be in stocks, subtract your age from 100. However, this is hardly a comprehensive strategy. Deciding on an appropriate asset allocation involves more than simply looking at your age. Your financial professional has the skill and tools to help you choose a combination that takes into account your goals, risk tolerance, and overall financial situation.

Balancing Your Investment Choices with Asset Allocation

A chocolate cake. Pasta. A pancake. They’re all very different, but they generally involve flour, eggs, and perhaps a liquid. Depending on how much of each ingredient you use, you can get very different outcomes. The same is true of your investments. Balancing a portfolio means combining various types of investments using a recipe that's right for you.

Getting the right mix

The combination of investments you choose can be as important as your specific investments. The mix of various asset classes, such as stocks, bonds, and cash alternatives, accounts for most of the ups and downs of a portfolio's returns.
There’s another reason to think about the mix of investments in your portfolio. Each type of investment has specific strengths and weaknesses that enable it to play a specific role in your overall investing strategy. Some investments may be chosen for their growth potential. Others may provide regular income. Still others may offer safety or simply serve as a temporary place to park your money. And some investments even try to fill more than one role. Because you probably have multiple needs and desires, you need some combination of investment types.
Balancing how much of each you should include is one of your most important tasks as an investor. That balance between growth, income, and safety is called your asset allocation, and it can help you manage the level and type of risks you face.

Balancing risk and return

Ideally, you should strive for an overall combination of investments that minimizes the risk you take in trying to achieve a targeted rate of return. This often means balancing more conservative investments against others that are designed to provide a higher return but that also involve more risk. For example, let’s say you want to get a 7.5% return on your money. Your financial professional tells you that in the past, stock market returns have averaged about 10% annually, and bonds roughly 5%. One way to try to achieve your 7.5% return would be by choosing a 50-50 mix of stocks and bonds. It might not work out that way, of course. This is only a hypothetical illustration, not a real portfolio, and there’s no guarantee that either stocks or bonds will perform as they have in the past. But asset allocation gives you a place to start.
Someone living on a fixed income, whose priority is having a regular stream of money coming in, will probably need a very different asset allocation than a young, well-to-do working professional whose priority is saving for a retirement that’s 30 years away. Many publications feature model investment portfolios that recommend generic asset allocations based on an investor’s age. These can help jump-start your thinking about how to divide up your investments. However, because they’re based on averages and hypothetical situations, they shouldn't be seen as definitive. Your asset allocation is—or should be—as unique as you are. Even if two people are the same age and have similar incomes, they may have very different needs and goals. You should make sure your asset allocation is tailored to your individual circumstances.

Many ways to diversify

When financial professionals refer to asset allocation, they’re usually talking about overall classes: stocks, bonds, and cash or cash alternatives. However, there are others that also can be used to complement the major asset classes once you’ve got those basics covered. They include real estate and alternative investments such as hedge funds, private equity, metals, or collectibles. Because their returns don’t necessarily correlate closely with returns from major asset classes, they can provide additional diversification and balance in a portfolio.
Even within an asset class, consider how your assets are allocated. For example, if you’re investing in stocks, you could allocate a certain amount to large-cap stocks and a different percentage to stocks of smaller companies. Or you might allocate based on geography, putting some money in U.S. stocks and some in foreign companies. Bond investments might be allocated by various maturities, with some money in bonds that mature quickly and some in longer-term bonds. Or you might favor tax-free bonds over taxable ones, depending on your tax status and the type of account in which the bonds are held.

Asset allocation strategies

There are various approaches to calculating an asset allocation that makes the most sense for you.
The most popular approach is to look at what you’re investing for and how long you have to reach each goal. Those goals get balanced against your need for money to live on. The more secure your immediate income and the longer you have to achieve your investing goals, the more aggressively you might be able to invest for them. Your asset allocation might have a greater percentage of stocks than either bonds or cash, for example. Or you might be in the opposite situation. If you’re stretched financially and would have to tap your investments in an emergency, you’ll need to balance that fact against your longer-term goals. In addition to establishing an emergency fund, you may need to invest more conservatively than you might otherwise want to.
Some investors believe in shifting their assets among asset classes based on which types of investments they expect will do well or poorly in the near term. However, this approach, called “market timing,” is extremely difficult even for experienced investors. If you’re determined to try this, you should probably get some expert advice—and recognize that no one really knows where markets are headed.
Some people try to match market returns with an overall “core” strategy for most of their portfolio. They then put a smaller portion in very targeted investments that may behave very differently from those in the core and provide greater overall diversification. These often are asset classes that an investor thinks could benefit from more active management.
Just as you allocate your assets in an overall portfolio, you can also allocate assets for a specific goal. For example, you might have one asset allocation for retirement savings and another for college tuition bills. A retired professional with a conservative overall portfolio might still be comfortable investing more aggressively with money intended to be a grandchild’s inheritance. Someone who has taken the risk of starting a business might decide to be more conservative with his or her personal portfolio.

Things to think about

  • Don’t forget about the impact of inflation on your savings. As time goes by, your money will probably buy less and less unless your portfolio at least keeps pace with the inflation rate. Even if you think of yourself as a conservative investor, your asset allocation should take long-term inflation into account.
  • Your asset allocation should balance your financial goals with your emotional needs. If the way your money is invested keeps you awake worrying at night, you may need to rethink your investing goals and whether the strategy you’re pursuing is worth the lost sleep.
  • Your tax status might affect your asset allocation, though your decisions shouldn’t be based solely on tax concerns.
Even if your asset allocation was right for you when you chose it, it may not be right for you now. It should change as your circumstances do and as new ways to invest are introduced. A piece of clothing you wore 10 years ago may not fit now; you just might need to update your asset allocation, too.
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Market Volatility: Looking for Opportunity

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In Chinese, the word “crisis” is composed of two parts. One symbolizes “danger;” the other represents “opportunity.” If you can keep your head while all around you are losing theirs, you may be able to take advantage of remarkable opportunities. Though all investing involves risk, including the possible loss of principal, and there can be no guarantee that any strategy will be successful, your financial professional may be able to help you decide if any of the following may be appropriate for you.

Rebalancing at a discount If you rebalance your portfolio periodically to try to maintain a certain percentage of your assets in a variety of investment types, market volatility might offer a good opportunity to consider your level of diversification. Rather than abandoning a single asset class entirely, you might look at adjusting your portfolio in a way that spreads your bets across a wider range of asset classes. Though diversification can’t guarantee a profit or insure against a loss, of course, it might help better position your portfolio for the future. And the silver lining to indiscriminate broad-based market turmoil is that depending on the types of investments you want to add to your portfolio, you may be able to acquire them at a discount.

Being willing to use tough times Anyone can look good during bull markets; being able to learn from a volatile market can better prepare you for the future. Sometimes the best strategy is to take a tax loss if that’s a possibility, learn from the experience, and apply the lesson to future decisions. There are other ways to wring some benefit from a down market. If you’ve been considering whether to convert a tax-deferred plan whose value has dropped dramatically to a Roth IRA, a lower account balance might make a conversion more attractive. Though the conversion would trigger federal income taxes, that tax would be based on the reduced value of your account. A financial professional can suggest whether and when a conversion might be advantageous. Also, some sound research might turn up buying opportunities on investments whose prices are down for reasons that have nothing to do with the fundamentals.

Playing defense During volatile periods in the stock market, many investors reexamine their allocation to such defensive sectors as consumer staples or utilities, which tend to experience relatively stable demand for their goods and services whether the economy is doing well or poorly (though like all stocks, those sectors involve their own risks). Businesses in defensive sectors aren’t immune from economic hard times, overall market movements, or problems within individual companies. However, the ups and downs of stocks considered “defensive” have generally been a bit less dramatic than in sectors where revenues are heavily affected by the economic climate (past performance is no guarantee of future results, of course). Dividends also can help cushion the impact of price swings. Dividend income has represented roughly one-third of the average monthly total return on the Standard & Poor’s 500 stocks since 1926.

Using cash to help manage your mindset Holding cash and cash alternatives can be the financial equivalent of taking deep breaths to relax. It can enhance your ability to make thoughtful investment decisions instead of impulsive ones. A cash position coupled with a disciplined investing strategy can change your perspective on market volatility. Knowing that you’re positioned to take advantage of a downturn by picking up bargains may increase your ability to be patient.

That doesn’t necessarily mean you should convert your entire portfolio into cash. A period of extreme market volatility can make it even more difficult than usual to pick the right time to make any large-scale move. Watching the market move up after you’ve abandoned it can be almost as painful as watching it go down. And are you sure you’ll be able to pick the right time to move back into the market? Finally, an all-cash portfolio may not keep up with inflation over time; if you have long-term goals, consider the impact of a major change on your ability to achieve them. An appropriate asset allocation that takes into account your time horizon and risk tolerance should provide you with enough resources on hand to prevent having to sell stocks to meet ordinary expenses or, if you’ve used leverage, a margin call.

Checking your withdrawal rate If you’re retired and relying on your investments to produce an income, market volatility can be especially challenging. If your nest egg has shrunk as a result of market turmoil, you may need to rethink the rate at which money is taken out. If you currently increase the amount you withdraw from your portfolio each year by enough to account for inflation, you may be able to do away with those increases for a year or two, especially if inflation is relatively benign.

If you’re withdrawing, say, 4% of your portfolio per year but you’re concerned about losses, you might consider not automatically withdrawing the same dollar amount in upcoming months. Instead, you could base your 4% withdrawals on your portfolio’s current value and withdraw that amount. For example, if you’ve been withdrawing 4% of a $1.2 million portfolio that is now worth $900,000, you could withdraw &36;36,000 next year—4% of $900,000—instead of the previous $48,000. You also may want some expert help in determining whether your withdrawal rate itself—the percentage of your portfolio you withdraw each year—needs to be adjusted. Trimming your budget or finding additional income sources might help you avoid having to sell at an inopportune time.

Staying on track by continuing to save Regularly adding to an account that’s designed for a long-term goal may cushion the emotional impact of market swings. If losses are offset even in part by new savings, the bottom-line number on your statement might not be quite so discouraging. If you’re using dollar-cost averaging—investing a specific amount regularly regardless of fluctuating price levels—you may be getting a bargain by continuing to buy when prices are down. However, you’ll also need to consider your financial and psychological ability to continue purchases through periods of low price levels or economic distress; dollar-cost averaging loses much of its benefit if you stop just when prices are reduced. And it can’t guarantee a profit or protect against a loss.

If you just can’t bring yourself to invest during a period of uncertainty, you could continue to save, but direct new savings into a cash equivalent investment until your comfort level rises. Though you might not be buying at a discount, you’d at least be creating a pool of money to invest when you’re ready. The key is not to let short-term anxiety make you forget your long-term plan.

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Why Europe Matters to Your Portfolio

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Ever since the possibility of default on Greek sovereign debt has become headline news, a lot of people have found themselves wondering, “How is it possible for the financial problems of a country so small and so far away to create such turmoil in the world’s markets?” What’s happening in Europe is probably affecting your portfolio right now, regardless of the quality of your holdings or how well diversified you are.

Just what is all the shouting about? It’s no secret that the so-called PIIGS nations (Portugal, Italy, Ireland, Greece, and Spain) are having difficulty coping with the debt that years of deficit spending have created. A robust global economy helped to mask the problem, but in recent years the burden of sovereign debt—bonds issued by sovereign governments-—has become increasingly unsustainable. With debt at roughly 140% of its gross domestic product,* Greece is particularly troubled. Imposing austerity measures required by its European colleagues has added to the country’s recessionary woes. That in turn has made it even more difficult to achieve mandated deficit reduction targets in order to qualify for additional installments of financial aid from the European Financial Stability Facility (EFSF) set up last year by 17 eurozone countries.

Bank exposure One of the chief concerns about the possibility of default on sovereign debt has to do with the financial stability of banks that hold it. Some of the largest French banks have already suffered downgrades of their credit ratings because of their extensive holdings of debt from troubled European countries, particularly Greece. If a Greek default made banks reluctant to lend to one another, that could affect credit markets worldwide.

American banks hold very little Greek debt compared to European banks; however, they could face a different challenge. Understanding why requires some basic awareness of a type of derivative known as a credit default swap. Investors with large bond holdings from a particular borrower often try to protect themselves against the possibility that the borrower will default by buying a credit default swap on that debt as a type of insurance. The company that issues the credit default swap agrees to cover the bondholder’s losses in case of default. The more risky the issuer—for example, Greece—the more likely bondholders are to try to protect themselves with swaps. However, in some cases, a company may have issued so many default swaps on a particular issuer that it could be overwhelmed by the claims resulting from the issuer's default.

Such derivatives can create a ripple effect in financial markets. If the company that issued the swaps can’t make good on them, the institutions that relied on that protection also can find themselves in trouble, which multiplies the impact of a major default. U.S. financial institutions are major issuers of credit default swaps, and the potential impact of a Greek default on them is unclear. However, since the 2008 financial crisis, U.S. banks have been forced to hold greater capital reserves to deal with contingencies, and Treasury Secretary Timothy Geithner recently said that banks here have reduced their exposure to the debt of troubled countries.

Potential for tighter credit leading to recession Lending worldwide hasn’t fully recovered from the last financial crisis, and has helped keep global economic recovery sluggish. Fiscal austerity measures taken to try to reduce deficits have also taken their toll, hampering economic growth and making it even more difficult for countries such as Greece to balance their budgets. If banks’ lending ability were impaired further by a financial crisis brought on by a default on sovereign debt, tighter credit could increase the odds of renewed recession.

Also, Europe represents a major market for many American companies, and a recession there wouldn’t help an already slowing global economy.

Greece could be the tip of the iceberg Even though Greece is the immediate concern, larger economies in Europe actually could represent a bigger threat. Italy and Spain both face sovereign debt burdens and deficit problems. Italy’s economy is more than five times that of Greece; Spain’s is more than four times bigger.* If either country were to decide it needed to restructure its debts as Greece is attempting to do (which ratings agencies could see as a form of default), that would have a much bigger impact than Greece. If a Greek default would have a ripple effect, a default by either Spain or Italy could cause waves.

To compound the problem, as investors have become increasingly concerned about the possibility of debt contagion in Europe, borrowing costs for both Italy and Spain have risen. At recent auctions, nervous investors have been demanding higher interest rates to compensate them for the higher perceived risk of buying that sovereign debt. As any credit card holder knows, having to pay a higher interest rate makes paying off debt and balancing the budget more difficult. A Greek default could make investors even more nervous about buying other troubled countries’ debt, and being frozen out of credit markets would likely aggravate fiscal problems abroad.

All politics is local

There have been signs in recent months that voters in stronger economies such as Germany are beginning to question why they should continue to support countries that have not been as disciplined about balancing their budgets. Also, investors worry that the financial support available from the EFSF may not be sufficient or available quickly enough to avert problems. Though there has been no shortage of suggestions for how to deal with the situation—issuance of euro bonds backed by all eurozone members, leveraging the EFSF’s existing assets, greater fiscal integration among countries, Greece returning to its own currency—questions about the ability and willingness of other countries to support the eurozone's weaker members have caused investor anxiety worldwide.

Financial markets hate uncertainty, and the situation has contributed to the recent volatility across a variety of asset classes that don't usually move in tandem. However, Europe has the benefit of having watched the United States deal with its own difficulties during the 2008 crisis. Also, European leaders have generally reaffirmed their determination to defend the euro at all costs.

Uncertainty about Europe could persist for months, but it’s important to keep it in perspective. While you should monitor the situation, don’t let every twist and turn derail a carefully constructed investment game plan.

*Source: CIA World Factbook 2011

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Estate Planning—An Introduction

By definition, estate planning is a process designed to help you manage and preserve your assets while you are alive, and to conserve and control their distribution after your death according to your goals and objectives. But what estate planning means to you specifically depends on who you are. Your age, health, wealth, lifestyle, life stage, goals, and many other factors determine your particular estate planning needs. For example, you may have a small estate and may be concerned only that certain people receive particular things. A simple will is probably all you’ll need. Or, you may have a large estate, and minimizing any potential estate tax impact is your foremost goal. Here, you’ll need to use more sophisticated techniques in your estate plan, such as a trust.


To help you understand what estate planning means to you, the following sections address some estate planning needs that are common among some very broad groups of individuals. Think of these suggestions as simply a point in the right direction, and then seek professional advice to implement the right plan for you.

Over 18

Since incapacity can strike anyone at anytime, all adults over 18 should consider having:

  • A durable power of attorney: This document lets you name someone to manage your property for you in case you become incapacitated and cannot do so.
  • An advanced medical directive: The three main types of advanced medical directives are (1) a living will, (2) a durable power of attorney for health care (also known as a health-care proxy), and (3) a Do Not Resuscitate order. Be aware that not all states allow each kind of medical directive, so make sure you execute one that will be effective for you.

Young and single

If you’re young and single, you may not need much estate planning. But if you have some material possessions, you should at least write a will. If you don’t, the wealth you leave behind if you die will likely go to your parents, and that might not be what you would want. A will lets you leave your possessions to anyone you choose (e.g., your significant other, siblings, other relatives, or favorite charity).

Unmarried couples

You’ve committed to a life partner but aren’t legally married. For you, a will is essential if you want your property to pass to your partner at your death. Without a will, state law directs that only your closest relatives will inherit your property, and your partner may get nothing. If you share certain property, such as a house or car, you might consider owning the property as joint tenants with rights of survivorship. That way, when one of you dies, the jointly held property will pass to the surviving partner automatically.

Married couples

For many years, married couples had to do careful estate planning, such as the creation of a credit shelter trust, in order to take advantage of their combined federal estate tax exclusions. A new law passed in 2010 allows the executor of a deceased spouse’s estate to transfer any unused estate tax exclusion amount to the surviving spouse without such planning. This provision is effective for estates of decedents dying after December 31, 2010 and before January 1, 2013.

You may be inclined to rely on these portability rules for estate tax avoidance, using outright bequests to your spouse instead of traditional trust planning. However, portability should not be relied upon solely for utilization of the first to die’s estate tax exemption, and a credit shelter trust created at the first spouse’s death may still be advantageous for several reasons:

  • Portability may be lost if the surviving spouse remarries and is later widowed again
  • The trust can protect any appreciation of assets from estate tax at the second spouse’s death
  • The trust can provide protection of assets from the reach of the surviving spouse’s creditors
  • Portability does not apply to the generation-skipping transfer (GST) tax, so the trust may be needed to fully leverage the GST exemptions of both spouses
  • Portability will expire in 2013 unless Congress enacts further legislation

Married couples where one spouse is not a U.S. citizen have special planning concerns. The marital deduction is not allowed if the recipient spouse is a non-citizen spouse (but a $136,000 annual exclusion, for 2011, is allowed). If certain requirements are met, however, a transfer to a qualified domestic trust (QDOT) will qualify for the marital deduction.

Married with children

If you’re married and have children, you and your spouse should each have your own will. For you, wills are vital because you can name a guardian for your minor children in case both of you die simultaneously. If you fail to name a guardian in your will, a court may appoint someone you might not have chosen. Furthermore, without a will, some states dictate that at your death some of your property goes to your children and not to your spouse. If minor children inherit directly, the surviving parent will need court permission to manage the money for them. You may also want to consult an attorney about establishing a trust to manage your children’s assets.

You may also need life insurance. Your surviving spouse may not be able to support the family on his or her own and may need to replace your earnings to maintain the family.

Comfortable and looking forward to retirement

You’ve accumulated some wealth and you’re thinking about retirement. Here’s where estate planning overlaps with retirement planning. It’s just as important to plan to care for yourself during your retirement as it is to plan to provide for your beneficiaries after your death. You should keep in mind that even though Social Security may be around when you retire, those benefits alone may not provide enough income for your retirement years. Consider saving some of your accumulated wealth using other retirement and deferred vehicles, such as an individual retirement account (IRA).

Wealthy and worried

Depending on the size of your estate, you may need to be concerned about estate taxes.

For 2011, $5 million is effectively exempt from the federal gift and estate tax. Estates over that amount may be subject to the tax at a top rate of 35 percent.

Similarly, there is another tax, called the generation-skipping transfer (GST) tax, that is imposed on transfers of wealth that are made to grandchildren (and lower generations). For 2011, the GST tax exemption is $5 million and the top tax rate is 35 percent.

Whether your estate will be subject to state death taxes depends on the size of your estate and the tax laws in effect in the state in which you are domiciled.

The $5 million exemption amounts mentioned above are set to expire after 2012. Unless Congress enacts further legislation, these amounts will revert to $1 million in 2013. Thus, if you have an estate valued in excess of $1 million, you might want to consider some tax planning.

Elderly or ill

If you’re elderly or ill, you’ll want to write a will or update your existing one, consider a revocable living trust, and make sure you have a durable power of attorney and a health-care directive. Talk with your family about your wishes, and make sure they have copies of your important papers or know where to locate them.

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Advantages of Trusts

Why you might consider discussing trusts with your attorney

financial planning consulting, annapolis, anne arundel county, maryland, md
  • Trusts may be used to minimize estate taxes for married individuals with substantial assets.
  • Trusts provide management assistance for your heirs.*
  • Contingent trusts for minors (which take effect in the event that both parents die) may be used to avoid the costs of having a court-appointed guardian to manage your children’s assets.
  • Properly funded trusts avoid many of the administrative costs of probate (e.g., attorney fees, document filing fees).
  • Generally, revocable living trusts will keep the distribution of your estate private.
  • Trusts can be used to dispense income to intermediate beneficiaries (e.g., children, elderly parents) before final property distribution.
  • Trusts can ensure that assets go to your intended beneficiaries. For example, if you have children from a prior marriage you can make sure that they, as well as a current spouse, are provided for.
  • Trusts can minimize income taxes by allowing the shifting of income among beneficiaries.
  • Properly structured irrevocable life insurance trusts can provide liquidity for estate settlement needs while removing the policy proceeds from estate taxation at the death of the insured.

*This is particularly important for minors and incapacitated adults who may need support, maintenance, and/or education over a long period of time, or for adults who have difficulty managing money.

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Conducting a Periodic Review of Your Estate Plan

What is conducting a periodic review of your estate plan?

With your estate plan successfully implemented, one final but critical step remains: carrying out a periodic review and update.

Imagine this: since you implemented your estate plan five years ago, you got divorced and remarried, sold your house and bought a boat to live on, sold your legal practice and invested the money that provides you with enough income so you no longer have to work, and reconciled with your estranged daughter. This scenario may look more like fantasy than reality, but imagine how these major changes over a five-year period may affect your estate. And that's without considering changes in tax laws, the stock market, the economic climate, or other external factors. After all, if the only constant is change, it isn’t unreasonable to speculate that your wishes have changed, the advantages you sought have eroded or vanished, or even that new opportunities now exist that could offer a better value for your estate. A periodic review can give you peace of mind.

When should you conduct a review of your estate plan?

Every year for large estates

Those of you with large estates (i.e., more than the federal or your state’s exemption amount, whichever is smaller) should review your plan annually or at certain life events that are suggested in the following paragraphs. Not a year goes by without significant changes in the tax laws. You need to stay on top of these to get the best results.

Every five years for small estates

Those of you with smaller estates (i.e., more than the federal or your state’s exemption amount, whichever is smaller) need only review every five years or following changes in your life events. Your estate will not be as affected by economic factors and changes in the tax laws as a larger estate might be. However, your personal situation is bound to change, and reviewing every five years will bring your plan up to date with your current situation.

Upon changes in estate valuation

If the value of your estate has changed more than 20 percent over the last two years, you may need to update your estate plan.

Upon economic changes

You need to review your estate plan if there has been a change in the value of your assets or your income level or requirements, or if you are retiring.

Upon changes in occupation or employment

If you or your spouse changed jobs, you may need to make revisions in your estate plan.

Upon changes in family situations

You need to update your plan if: (1) your (or your children’s or grandchildren’s) marital status has changed, (2) a child (or grandchild) has been born or adopted, (3) your spouse, child, or grandchild has died, (4) you or a close family member has become ill or incapacitated, or (5) other individuals (e.g., your parents) have become dependent on you.

Upon changes in your closely held business interest

A review is in order if you have: (1) formed, purchased, or sold a closely held business, (2) reorganized or liquidated a closely held business, (3) instituted a pension plan, (4) executed a buy-sell agreement, (5) deferred compensation, or (6) changed employee benefits.

Upon changes in the estate plan

Of course, if you make a change in part of your estate plan (e.g., create a trust, execute a codicil, etc.), you should review the estate plan as a whole to ensure that it remains cohesive and effective.

Upon major transactions

Be sure to check your plan if you have: (1) received a sizable inheritance, bequest, or similar disposition, (2) made or received substantial gifts, (3) borrowed or lent substantial amounts of money, (4) purchased, leased, or sold material assets or investments, (5) changed residences, (6) changed significant property ownership, or (7) become involved in a lawsuit.

Upon changes in insurance coverage

Making changes in your insurance coverage may change your estate planning needs or may make changes necessary. Therefore, inform your estate planning advisor if you make any change to life insurance, health insurance, disability insurance, medical insurance, liability insurance, or beneficiary designations.

Upon death of trustee/executor/guardian

If a designated trustee, executor, or guardian dies or changes his or her mind about serving, you need to revise the parts of your estate plan affected (e.g., the trust agreement and your will) to replace that individual.

Upon other important changes

None of us has a crystal ball. We can’t think of all the conditions that should prompt us to review and revise our estate plans. Use your common sense. Have your feelings about charity changed? Has your son finally become financially responsible? Has your spouse’s health been declining? Are your children through college now? All you need to do is give it a little thought from time to time, and take action when necessary.

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Optimal Asset Allocation in Retirement: A Downside Risk Perspective

Once an individual has retired, asset allocation becomes a critical investment decision. Unfortunately, there is no consensus on what the optimal allocation should be for retirees of varying age, gender, and risk tolerance. This study analyzes the allocation question through a focus on the downside risks created by uncertainty over investment returns and life expectancy. We find that the range of appropriate equity asset allocations in retirement is strikingly low compared with those of typical lifecycle and retirement funds now in the marketplace. In fact, for retirement portfolios whose primary goal is to minimize the risk of depletion and sustain withdrawals, optimal equity allocations range between 5% and 25%. This quite conservative level of equity holdings changes little even when we significantly change our assumptions on capital market returns. We even find that more aggressive equity allocations, those that still retain some focus on depletion risk but also seek to provide substantial bequests to heirs, are also relatively conservative. The study suggests, in short, that the higher equity allocations used in many popular retirement investment products today significantly underestimate the risks that these higher-volatility portfolios pose to the sustainability of retirees’ savings and to the incomes they depend on. Read full article »

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